A day after adopting a hawkish stance on the way forward where it clearly said the space for action by it in 2013-14 was ‘very limited’, the Reserve Bank of India (RBI) has gone with what was widely expected and announced a 25 basis points cut in the benchmark repo rate in its 3 May Monetary Policy statement for the year.
Though factored in by the markets, the 25 bps repo rate cut does underscore the fact that there was just enough headroom for the central bank to effect one round of monetary easing before it turns cautious again, given the macroeconomic scenario domestically and globally. However, despite some sections suggesting that there was a need for a cut in the cash reserve ratio (CRR) – the portion of net demand and time liabilities banks have to park with RBI – to enable better monetary transmission, the central bank has refrained from that step. It’s only the 25 bps for now, with a clear indication that this may be all for now.
The RBI says this clearly in its guidance. “Overall, the balance of risks stemming from the Reserve Bank’s assessment of the growth-inflation dynamic yields little space for further monetary easing,” it says, moving from the ‘very limited’ phrase to ‘little space’ and making its stance evident. However, it does continue to promise that it “will endeavour to actively manage liquidity to reinforce monetary transmission, consistent with the growth-inflation balance.”
Another very significant takeaway from the policy statement is the sharp lowering of growth estimates for 2013-14. Pegging growth for 2013-14 at 5.7 percent – much lower than the Prime Minister’s Economic Advisory Council optimistic projection of 6.4 percent— the central bank says economic activity will show only a modest improvement over the past year, and a pick-up could only be likely in the second half. The outlook, the central bank says, remains subdued, with the pipeline of new investment drying up and existing projects stalled by bottlenecks and ‘implementation gaps.’
This, together with the fact that global growth is seen unlikely to improve significantly over 2012 levels in 2013 and will impact growth in services and exports, has led RBI to significantly lower its growth estimate for the current fiscal.
The reason why RBI remains hawkish despite the 25 bps cut is not difficult to understand. Reiterating its stand that the effectiveness of monetary policy in containing inflation could easily be undermined by supply constraints in the economy, the central bank points to the critical role of the government in ensuring these bottlenecks are addressed urgently.
“Food price pressures, upward revisions in the MSPs and rapid wage increases are leading to a wage-price spiral. Without policy efforts to unlock the tightening supply constraints and bring enduring improvements in productivity and competitiveness, growth could weaken even further and inflationary strains could re-emerge,” RBI warns.
The Biggest Risk
The biggest risk the central bank sees to the economy is the ballooning current account deficit (CAD) which remains well above the sustainable level of 2.5 percent of GDP. In fact, the central bank goes on to say that even if one accounted for the fact that the fiscal deficit is “programmed to decline,” the CAD was still high. “Large fiscal deficits can potentially spill over into the CAD and undermine its sustainability even further.A large CAD, appreciably above the sustainable level year after year, will put pressure on servicing of external liabilities,” the policy statement points out.
“Even as the large CAD is a risk by itself, its financing exposes the economy to the risk of sudden stop and reversal of capital flows,” it says, adding, “Should global liquidity conditions rapidly tighten, India could potentially face a problem of sudden stop and reversal of capital flows jeopardising our macro-financial stability.”
Pointing to lenders becoming risk averse and the investment sentiment remaining inhibited, the RBI paints a rather gloomy picture of the overall economic conditions, saying borrowers have become risk averse owing to governance concerns, delayed approvals and tighter credit conditions.
In line with the macroeconomic review of 2 May, the central bank projects inflation to be range-bound at around 5.5 percent in the fiscal, with the possibility of an increase in the second half owing to base effects. This is mainly owing to the demand-supply balance, easing of global commodity prices and the forecast of a normal monsoon.
While the RBI says monetary policy stance is intended to “continue to address the accentuated risks to growth,” the other major imperative is “to guard against the risks of inflation pressures re-emerging and adversely impacting inflation expectations, even as corrections in administered prices release suppressed inflation.” The third imperative is “to appropriately manage liquidity to ensure adequate credit flow to the productive sectors of the economy.”
For now, the central bank has acknowledged the serious risks to the growth momentum and continued with its stance of monetary easing. But the policy statement is enough indication of its keenness to anchor expectations going forward as risks remain heightened and could threaten to destabilize the economy any time. These risks will weigh heavily on RBI’s mind in the days ahead.